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Understanding Quantitative Easing

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Let’s say there was a prosperous village –Sukhsagar. Most of the villagers were intoagriculture, and their lands were fertile and the farmers were happy.

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The village had good schools, shops, entertainmenthubs, hospitals, municipalities, et c.

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One day, a pundit who was well respected amongst the villagers, came to visit. The villagers believed the pundit wasblessed with the ability to predict the future.

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One evening, the pundit called for an urgent meeting to tell the villagers abouttheir future. These meetings had become a regular occurrence and most peopleattended it because the pundit’s prediction often was accurate.

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During the meeting, the pundit hadbad news for the villagers. He told themthat he expected that the villagers would soon lose their jobs and source of livelihood. Their incomes would vanish!

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The pundit urged them to store all they had so they could overcome the bad times. The petrified villagers acted upon hisinstruction without any further delay. Theybegan to save their money like there was no tomorrow.

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People stopped visiting the markets, theystopped going to the entertainment hub.Every place in Sukhsagar was deserted. The fear of losing jobs and source ofincome was sucking out every aspect of happiness from their lives.

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The demand for all goods and servicesnosedived. The producers of goods felt thepain and reduced prices to get some hold on their lives. But the demand simply did not lift.

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Clearly, negative sentiments had come toenshroud the entire village leading into a standstill of economic activity. One day, a government official came toSukhsagar but quickly noticed that it had turned into Dukhsagar.

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The official tried to convince the villagersthat there was no imminent danger of bad times befalling on them.However they remained to live in fear. They had more faith in the pundit than the official.

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Seeing that his advice was falling on deafears, he invited another learned person to address the villagers. But all his efforts were in vain.

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Soon the villagers started suffering. Theproducers of goods and services suffereddue to a fall in the demand. So either they closed shop or left the village. So now, there was even a shortage of goods.

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Since there was no demand, the prices had stopped falling. So while people hadmoney in their homes and prices had come down still there was no economic activity!Without economic activity, the markets had dried up just like a car would get stalled without petrol.

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Just like car engine would get dehydrated without petrol, so did the markets in the village in the absence of money. Themoney that was not reaching the marketseven though there was plenty of it in the homes of the villagers.

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There was only pain and misery left in the village. Although there was no externalthreat to their jobs, the peculiar behavior of the villagers to save money and stopbuying goods and services was turning out to be the cause of job losses.

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The government official was afraid thevillagers would destroy themselves if theycontinued on this path. So he thought of an idea to help the villagers get out of their pessimism.He made an unprecedented announcement to jolt the villagers into action.

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The key parts of his announcement were:-1. Money would be made available to everybody at 0%interest2. As much money that would be needed would beprovided3. Villagers could pay their debts over a comfortableperiod of time4. The government would take on the debts that othersowed them

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This announcement was manna from heaven for the villagers.The assurance of easy money made themrealize that it was futile to hoard money intheir homes. They started to buy goods and services from the market.

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Soon, the producers of other goods andservices who had fled from the village started to return in large numbers. And even the entertainment hub sprung into action.The economic engine sputtered into action just as a car engine would when supply of fuel resumes.

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The sentiments of the villagers took a U turn from negativity to positivity andDukhsagar turned back into Sukhsagar.

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The process of releasing money into thehands of people to revive sentiment and getting people to actively participate in economic activity is what is known as “Quantitative Easing”. Quantitative Easing literally means increasing the supply of money in theeconomy by printing additional currency.

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The cheap money released became an incentive for the people to consume and invest. While consumption increases, thedemands of goods and services infuses life to the production process.

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Changing sentiments is a self fulfilling prophecy that helps the economy gain momentum and sustain itself. The moment sentiments change, peopleare inclined to hoard less and inject more money into the economy. The infusedmoney acts a the lubricant for the economy to chug along smoothly.

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Hope this story has clarified Quantitative Easing Please give us your feedback at professor@tataamc.com

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Disclaimer The views expressed in these lessons are for information purposes only and do not construe to be of any investment, legal or taxation advice. They are not indicative of future market trends, nor is Tata Asset Management Ltd. attempting to predict the same. Reprinting any part of this presentation will be at your own risk and Tata Asset Management Ltd. will not be liable for the consequences of any such action.Mutual Fund investments are subject to market risks, read all schemerelated documents carefully.